Beat Earnings Benchmarks Research Articles

The Dark Side of Industry Tournament Incentives

Top executives’ reputation and rewards from the managerial labor market are at least partly determined by the financial information their firms convey to the capital markets. We thus examine whether managerial labor market incentives influence firms’ choices in such information transmission and whether these choices subsequently affect future outcomes in the managerial labor market. Our findings are consistent with a strategic information distortion hypothesis. Specifically, CEOs facing greater labor market incentives are more likely to engage in strategic financial disclosure choices to inflate their firms’ reported performance and to meet or narrowly beat earnings benchmarks, thereby enhancing their reputation and upward mobility in the labor market. At the same time, these CEOs are more careful not to commit disclosure maneuvers that trigger financial fraud and restatements, which will severely damage their reputation and undermine their future career prospects. These empirical patterns portray a nuanced picture of how CEOs respond strategically to labor market incentives and career concerns in making financial disclosure decisions. We further show that these decisions affect managerial labor market outcomes; consistent marginal benchmark beating leads to higher compensation and greater mobility in the labor market for CEOs.

Ownership structure of a company and accounting earnings management

The objective of our study is to investigate whether the ownership structure of a company, including ownership concentration, managerial ownership and the presence of institutional investors, affects accrual earnings management practices. We first modelled discretionary accruals using the modified approach of Jones (1991), and then we built the model describing the relationship between discretionary accruals and elements of ownership structure of companies and control variables, determining regression using the least square method. We provided evidence of negative dependence between the magnitude of accrual earnings management and shareholder concentration. We do not corroborate the relationship between accrual earnings management and managerial ownership. The presence of institutional investors reduces the magnitude of accrual earnings management. We do not provide evidence that the presence of State Treasury affects accrual earnings management. We do not confirm that accrual earnings management is used for meeting or beating earnings benchmarks.

Motivations for Classification Shifting: A Systematic Review

The purpose of the current paper is to highlight the motivations that may encourage managements of firms to shift core expenses to special items in order to inflate core or operating earnings i.e. to practice classification shifting, which would have an effect on the decisions of financial statements' users. This was done through conducting a systematic review on the available literature about classification shifting. The most obvious findings to emerge from this study is that management may engage in classification shifting for the reason that it is less costly than other earnings management methods, the firm being in current or potential state of financial distress, the desire of the management of the firm to meet or beat earnings benchmarks, the ownership structure of the firm having some characteristics that encourage management to engage in such a practice, the firm performing in a weak corporate governance environment, or due to the fact that classification shifting is tough to be detected by external monitors compared to other earnings management methods.

Does late 10K filing impact companies’ financial reporting strategy? Evidence from discretionary accruals and real transaction management

AbstractThe study investigates how late 10K filers adapt their financial reporting strategy in the post‐late filing period in their response to bad publicity, negative market sentiment, and higher stakeholders’ scrutiny resulting from reporting delays. Both the level and change regressions show that late 10K filers significantly reduce the use of discretionary accruals from pre‐ to post‐late filing year. However, they simultaneously increase real transaction management over the same time period. The trade‐offs between the two earnings management techniques are more prominent when the late filers have a strong incentive to meet or beat earnings benchmarks. Our primary results are robust when late filings are caused by accounting, auditing, and internal control issues, and when the late filers cited no meaningful reason for late 10K filings. It is further evident that late filers with material internal control weaknesses and late filers that subsequently restate their financial statements make relatively higher trade‐offs than the matched non‐late filers. Finally, the trade‐offs between reduced accruals and increased real transaction management are stronger for the accelerated filers, and for the late filers audited by Big 4 auditors.

Overseeing the External Audit Function: Evidence from Audit Committees’ Reported Activities

Although one of the most crucial responsibilities of audit committees is overseeing the audit process, we know very little about how audit committees fulfill this role and how their oversight impacts audit quality. Recently, in response to calls for more transparency, many firms have begun reporting their audit committees’ oversight activities. We create a composite measure that captures the extent of audit committees’ reported oversight over the external audit. We find that when firms’ audit committees report exerting strong oversight, they have higher audit quality as proxied by discretionary accruals, audit fees, the likelihood of meeting or beating earnings benchmarks, and restatements. We also find that the market reacts positively to reports indicating strong oversight, consistent with perceptions of higher audit quality. This study extends prior literature on audit committees by introducing a new comprehensive measure of audit committees’ reported oversight activities and sheds light on how these activities map into audit quality.

The association between fair value measurements and banks' discretionary accounting choices

This study examines the association between fair value measurements and banks' discretionary loan loss provisions using regulatory financial data from 2009 to 2016 for a sample of U.S. public bank holding companies. I find that banks recognizing larger proportions of fair value assets and liabilities based on level 2 and level 3 inputs are associated with lower discretionary loan loss provisions. However, there is no significant association between level 1 fair value assets and liabilities and discretionary loan loss provisions. When pre-managed earnings are lower, banks with larger proportions of level 2 and level 3 fair value assets and liabilities report smaller discretionary loan loss provisions to inflate earnings. Banks reporting larger proportions of level 2 and level 3 fair value assets and liabilities are more likely to use discretionary loan loss provisions to beat earnings benchmarks and manage tier one capital ratios. Overall, the results support the proposition that fair value assets and liabilities based on level 2 and level 3 inputs are less transparent and are subject to more discretion regarding loan loss provisions.

Product Market Competition and Real Earnings Management to Meet or Beat Earnings Benchmarks

Targets provide incentives for earnings management, and a longstanding question is whether earnings management is undertaken opportunistically or to communicate private information about future firm value. To discriminate between these motivations, I follow analytical research showing that an increase in competition through a large decrease in tariffs disciplines managers and better aligns their interests with those of shareholders. Thus, if earnings management reflects managerial opportunism, then an increase in competition will decrease earnings management; and if it signals future performance expectations, then an increase in competition will increase earnings management. Consistent with earnings management indicating managerial opportunism, I show that an increase in competition decreases real earnings management to avoid reporting negative earnings or a negative change in earnings. In addition, by showing that the lessening of trade barriers through import tariff reductions reduces the use of real earnings management to meet or beat earnings targets, I provide evidence on the role of macroeconomic conditions as a determinant of earnings quality.

Managerial entrenchment and earnings management

Agency theorists have long contended that managerial entrenchment is detrimental for shareholders, because it protects managers from the discipline of corporate governance. However, asa competing hypothesis, we argue that entrenchment can also provide benefits for the firm’s owners: it leads managers to be less myopic in managing earnings to meet short-term financial reporting goals. Our findings are consistent with this prediction as they suggest that, when there are incentives to manipulate firms’ performance, entrenched managers are less prone to engage in earnings management activities that hurt shareholders. Specifically, we focus on firms that just meet or marginally beat earnings benchmarks and document a negative association between managerial entrenchment and both the opportunistic use of accruals and the manipulation of real activities. We also show that earnings management is less detrimental to firm value if the manager is entrenched. Finally, we find that these effects of entrenchment on earnings management are only present for firms domiciled in Delaware.

Do financially distressed firms misclassify core expenses?

PurposeThis paper aims to examine whether financially distressed firms manipulate core or operating income through the misclassification of operating expenses as income-decreasing special items.Design/methodology/approachThis sample comprises firms in the USA with data from 1989 to 2010. The authors used the methodology given in McVay (2006) and multiple regressions.FindingsManagers of financially distressed firms are more likely to inflate core or operating income as compared to the healthy firms to meet or beat earnings benchmarks. They do so by misclassifying core or operating expenses as income-decreasing special items. Specifically, core expenses are shifted to income-decreasing special items like goodwill impairments, settlement costs, restructuring costs and write downs.Practical implicationsThe paper sheds light on an important firm characteristic, financial distress that intensifies classification shifting – an earnings management tool which auditors, investors and regulators find tough to detect. The findings have implications for investors, as they fail to comprehend such shifting (McVay, 2006); analysts, who issue forecasts based on street earnings; lenders, as distressed firms may be concealing their true performance; and regulators, as the misclassification of income statement items is a violation of accounting principles.Originality/valueThe authors extend the literature on accruals and real earnings management by the financially troubled firms and present first evidence that the managers of such firms also manipulate core or operating income through classification shifting.

Exploring Managers' Accrual-Related Forecast Bias

In this study, we examine the effect of accrual-based earnings management on the association between managers’ earnings forecast errors and accruals, which we label “managers’ accrual-related forecast bias.” We build on extensive research which finds that managers engage in accrual-based earnings management to meet or beat earnings benchmarks and report smooth earnings series. We hypothesize that managers bias their subsequent-year forecasts in the direction of accruals management to increase market confidence in the managed earnings numbers. Consistent with our expectations, we find a positive association between managers’ earnings forecast errors and discretionary accruals, but no association between managers’ earnings forecast errors and nondiscretionary accruals. Furthermore, the association between managers’ earnings forecast errors and discretionary accruals is stronger when managers have limited ability to continue managing subsequent-year accruals to support the bias in their forecasts. We also find a substantial decline in managers’ accrual-related forecast bias following the enactment of the Sarbanes-Oxley Act of 2002 (SOX), which restricted managers’ use of accrual-based earnings management. More importantly, we find that the effect of forecasting difficulty on managers’ accrual-related forecast bias occurs only in the pre-SOX period. Overall, our results suggest that, contrary to claims in prior research, managers’ accrual-related forecast bias is not simply a product of forecasting difficulty related to accruals. Rather, at least in some cases, it appears to be intentional.

Corporate Life Cycle and Earnings Benchmarks

We examine whether and how corporate life cycle significantly influences meeting or beating earnings benchmarks (MBE). We find that corporate life cycle plays a significant role in a firm's meeting or beating earnings benchmarks behaviour. Developing strategies that fit into the stage of corporate life cycle is crucial for corporate success. MBE is an important financial goal that requires strategies. In this study, we examine whether and how corporate life cycle significantly influences MBE. Specifically, we focus on the incentives of MBE in growth and mature firms. We find that corporate life cycle significantly influences a firm's tendency to meet or beat zero earnings, prior earnings and analysts’ earnings forecasts. Based on logit regressions for the period from 1988 to 2008, the results indicate that growth firms are more likely to meet or beat all three earnings benchmarks. Overall, the results of this study indicate that a firm's MBE behaviour should be examined in the context of its life cycle stage.

Internal control weaknesses and evidence of real activities manipulation

We examine whether US public firms that file internal control weakness (ICW) disclosure reports with the Securities and Exchange Commission, as part of the reporting requirements under Section 404 of the Sarbanes–Oxley (SOX) Act, exhibit higher levels of real activities manipulation (RM), compared to firms that do not file such reports. Using firm-level data for the post-SOX period, 2004–2010, we find a positive relationship between firms reporting internal control weaknesses and real activities manipulation. Further, those ICW-firms that use RM to beat earnings benchmarks have lower performance in the subsequent year. Our results also show that firms do not use discretionary accruals as a substitute for RM when they report internal control weaknesses. Overall, our findings suggest that ICW-firms are prone to using real activities manipulation as a form of earnings management. Our findings also have implications for audit quality as auditors need to gain a better understanding of how real activities manipulation influences the operations of the firm.

Discretion in bank loan loss allowance, risk taking and earnings management

AbstractWe study whether banks use the allowance for loan losses (ALL) for efficiency or for opportunistic reasons. We find that banks that had higher abnormal ALL during the period prior to the 2007–2009 crisis engaged in less risk taking during the pre‐crisis period and had a lower probability of failure during the crisis period. In testing earnings management to meet or beat earnings benchmarks, we find that abnormal ALL is unrelated to next period's loss avoidance and just meeting or beating the prior year's earnings. Our results suggest that banks use ALL for efficiency and not for opportunistic purposes.

Overlapping Membership on Audit and Compensation Committees and Financial Reporting Quality

This paper examines whether the audit committee members of a board improve financial reporting quality if they are also on their organisation's compensation committee. Audit committees are responsible for overseeing the financial reporting process of organisations and have been urged to broaden their understanding of business risk and of the incentives provided by their firms’ executive compensation structures. Acknowledging the interrelationships among executive compensation, risk‐taking and financial reporting quality, members of audit and compensation committees have been advocating more information sharing between the two committees. Using archival data from a sample of Australian Stock Exchange listed companies, and discretionary accruals as a proxy for financial reporting quality, this study finds that firms with overlapping committees have better quality financial reporting than those without such an overlap. Our evidence for this is stronger in cases where managers tend to manage earnings upwards in order to meet or beat earnings benchmarks. We also find that the beneficial effect of the existence of overlapping committees is adversely affected by the equity holdings of directors with overlapping memberships.

The moderating effect of CEO profile on the link between cutting R&D expenditures and targeting to meet/beat earnings benchmarks

“Anybody can manage short, anybody can manage long, balancing those two things is what management is” (Jack Welch, Ex General Electric CEO). Drawing from a broad theoretical base, this article emphasizes the relationship of CEO traits with real-based earnings management through discretionary R&D expenses and targeting to meet or just beat earnings benchmarks. The analysis is based on a sample of European firms listed on Stoxx Europe 600 index spanning the years 2000–2014. Evidence reveals that (i) achieving earnings targets, (ii) CEO overconfidence, (iii) CEO tenure, (iv) CEO age, and (v) CEO education are significantly associated with cutting R&D expenditures. Findings suggest also that (vi) when firms use abnormal discretionary expenditure as method of earnings management to meet/beat earnings benchmarks, the CEO profile is a moderator variable in a such relation.

Internal Governance and Real Earnings Management

ABSTRACT We examine whether internal governance affects the extent of real earnings management in U.S. corporations. Internal governance refers to the process through which key subordinate executives provide checks and balances in the organization and affect corporate decisions. Using the number of years to retirement to capture key subordinate executives' horizon incentives and using their compensation relative to CEO compensation to capture their influence within the firm, we find that the extent of real earnings management decreases with key subordinate executives' horizon and influence. The results are robust to alternative measures of internal governance and to various approaches used to address potential endogeneity, including a difference-in-differences approach. In cross-sectional analyses, we find that the effect of internal governance is stronger for firms with more complex operations where key subordinate executives' contribution is higher, is enhanced when CEOs are less powerful, is weaker when the capital markets benefit of meeting or beating earnings benchmarks is higher, and is stronger in the post-SOX period. This paper contributes to the literature by examining how internal governance affects the extent of real earnings management and by shedding light on how the members of the management team work together in shaping financial reporting quality. JEL Classifications: G32; M40.

Managing the Numbers Smartly: Rewards and Reputation from the Managerial Labor Market and Strategic Disclosure Choices

Top executives’ reputation and rewards from the managerial labor market are at least partly determined by the financial information their firms convey to the capital markets. We thus examine whether managerial labor market incentives influence firms’ choices in such information transmission and whether these choices subsequently affect future outcomes in the managerial labor market. Our findings are consistent with a strategic information distortion hypothesis. Specifically, CEOs facing greater labor market incentives are more likely to engage in strategic financial disclosure choices to inflate their firms’ reported performance and to meet or narrowly beat earnings benchmarks, thereby enhancing their reputation and upward mobility in the labor market. At the same time, these CEOs are more careful not to commit disclosure maneuvers that trigger financial fraud and restatements, which will severely damage their reputation and undermine their future career prospects. These empirical patterns portray a nuanced picture of how CEOs respond strategically to labor market incentives and career concerns in making financial disclosure decisions. We further show that these decisions affect managerial labor market outcomes; consistent marginal benchmark beating leads to higher compensation and greater mobility in the labor market for CEOs.

Busyness, Expertise, and Financial Reporting Quality of Audit Committee Chairs and Financial Experts

SUMMARYWe investigate how the number of audit committee chair positions and other audit committee financial expertise positions held by the audit committee chairman and the audit committee financial experts affects their ability to oversee a company's financial reporting process. We argue that these two audit committee roles are vital to the functioning of the audit committee and that their over commitment affects audit committee oversight and the firm's financial reporting quality. We observe a significant negative association between financial reporting quality and the number of audit committee chair positions and other audit committee financial expertise positions held by the audit committee chairman. We also find a significant negative association between financial reporting quality and the number of audit committee chair positions and other audit committee financial expertise positions held by audit committee financial experts. Firms with busy audit committee chairs or busy financial experts have significantly higher levels of abnormal accruals, and are more likely to meet or beat earnings benchmarks, which is consistent with the busyness hypothesis. This adverse effect, nonetheless, does not extend to nonaudit committee chairs and nonaudit committee financial experts. We interpret these results to indicate that the busyness of the audit committee chair and financial expert weakens the monitoring and oversight role that audit committees play in the financial reporting process.

Overlapping Membership on Audit and Compensation Committees, Audit Committee Equity Holdings, and Financial Reporting Quality

This paper examines whether audit committee members of a board improve financial reporting quality if they are also on their organization’s compensation committee. Audit committees are responsible for overseeing the financial reporting process of organizations and have been urged to broaden their understanding of business risk and of the incentives provided by their firms’ executive compensation structures. Acknowledging the interrelationships among executive compensation, risk taking and financial reporting quality, members of audit and compensation committees have been advocating more information-sharing between the two committees. Using archival data on a sample of Australian Stock Exchange listed companies, and discretionary accruals as a proxy for financial reporting quality, this study finds that firms with overlapping committees have better quality financial reporting than those without such overlap. Our evidence for this is stronger in cases where managers tend to manage earnings upwards in order to meet or beat earnings benchmarks. We also find that the beneficial effect of the existence of overlapping committees is adversely affected by the equity holdings of directors with overlapping memberships.

To what extent does the audit committee curb downward earnings forecast guidance?

Purpose – The purpose of this paper is to examine the association between audit committee characteristics and a firm’s ability to guide analysts’ forecasts downward to meet or beat earnings benchmarks. Design/methodology/approach – The authors expect that a more effective audit committee would be able to reduce managers’ propensity to use downward forecast guidance to avoid negative earnings surprises. Four committee characteristics are used to measure its effectiveness: independence, diligence, expertise and size. Findings – For the pre-SOX (Sarbanes-Oxley Act) period (1996-2002), none of the four audit committee characteristics are significantly associated with managers’ propensity to use downward forecast guidance to avoid negative earnings surprises. For the post-SOX era (2003-2004), however, the likelihood of engaging in downward forecast guidance is significantly lower for firms with larger and more independent audit committees. In addition, the likelihood is significantly lower for audit committees that are more diligent and have a higher proportion of the committee members with accounting or finance-related expertise. Research limitations/implications – Overall, the authors results suggest that, in response to the increased regulatory and listing requirements in the post-SOX era, audit committees have played a more active role in scrutinizing earnings guidance. Our results also suggest that a more effective audit committee in the post-SOX era curbs managers’ tendency to use downward forecast guidance to meet or beat quarterly earnings targets. Originality/value – To the authors knowledge, this study is one of the first to examine the role of the audit committee in reviewing managerial earnings guidance. As earnings guidance plays an important role in the overall financial reporting process over time and given the increasing importance of downward forecast guidance in earnings surprise games in recent years, the authors believe this study addresses an important question and adds to prior literature. Also, this study contributes to their understanding of the changing nature and scope of audit committee oversight activities since the passage of SOX.